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According to Angela Merkel, speaking in the German city of Mainz last week, European countries strugglin with the fallout of the euro-area debt crisis have much to learn from East Germany’s experience with economic overhaul following the fall of the Berlin Wall. In the main she was speaking about the need for reform, something on which we can all agree. “At the beginning of the 21st century", she said, "Germany was the sick man of Europe and that we are where we are today also has to do with reforms we carried out in the past. That’s why we can say in Europe that change can lead to good.”

But there was one tiny little detail she forgot to mention. During the post unification period East Germany's population went into melt-down mode. New York Times Columnist Nicholas Kulish put it like this:

Unemployment in the former East Germany remains double what it is in the west, and in some regions the number of women between the ages of 20 and 30 has dropped by more than 30 percent. In all, roughly 1.7 million people have left the former East Germany since the fall of the Berlin Wall, around 12 percent of the population, a continuing process even in the few years before the economic crisis began to bite.

And the population decline is about to get much worse, as a result of a demographic time bomb known by the innocuous-sounding name “the kink,” which followed the end of Communism. The birth rate collapsed in the former East Germany in those early, uncertain years so completely that the drop is comparable only to times of war, according to Reiner Klingholz, director of the Berlin Institute for Population and Development. “For a number of years East Germans just stopped having children,” Dr. Klingholz said.

The newspaper Frankfurter Allgemeine Zeitung reported recently that although 14,000 young people would earn their high school diplomas this year in Saxony, only 7,500 would do so next year. Since 1989, about 2,000 schools have closed across the former East Germany because of a scarcity of children.

Now this situation is quite serious, and needs a long term solution, but it is not as serious as what is currently happening to Latvia, or Bulgaria, or a number of the other former communist states. Unless, of course, the lesson Angela would like to draw our attention to is that East Germany managed to salvage something from what would otherwise be population wreckage by sneaking in under the shelter of another state, with a centralized system of support for pensions and health care. Somehow I doubt it, but perhaps this is what we need to think more about. The EU needs a pan European health and pension system, to distribute the burden equitably. This is the conclusion I reached during my last visit to Riga. It isn't just a Euro related issue, it is to do with having a unified labour market, with people able to move to where the jobs exist, and the pay is better. For years people complained about the absence of labour mobility in the EU. Now we have it, the flaw in the institutional infrastructure is obvious.

Young people are moving from the weak economies on the periphery to the comparatively stronger ones in the core, or out of an ever older EU altogether. This has the simple consequence that the deficit issues in the core are reduced, while those on the periphery only get worse as health and pension systems become ever less affordable. Meanwhile, more and more young people follow the lead of Gerard Depardieu and look for somewhere where there isn't such a high fiscal burden, preferably where the elderly dependency ratio isn't shooting up so fast.

I am sufficiently concerned about this issue, which I think ultimately endangers possibilities of economic recovery all along the periphery, to have created a dedicated facebook page, campaigning for one single issue - that the EU Commission and the IMF give a greater priority to trying to measure these flows, and understand their consequences. I am simply asking that they pressure EU member states to improve their statistics gathering, treat the issue as a priority, and identify an indicator to incorporate in the Macroeconomic Imbalance Procedure (MIP) Scoreboard. Really it doesn't matter whether you are in favour of austerity, or against it, feel more Keynesian than Austrian, or vice versa, all I am asking for is that this problem be taken more seriously, measured and studied.

According to Angela Merkel, speaking in the German city of Mainz in mid February, European countries struggling with the fallout of the euro-area debt crisis have much to learn from East Germany’s experience with economic overhaul following the fall of the Berlin Wall. In the main she was speaking about the need for reform, something on which we can all agree. “At the beginning of the 21st century", she said, "Germany was the sick man of Europe and that we are where we are today also has to do with reforms we carried out in the past. That’s why we can say in Europe that change can lead to good.”

But there was one tiny little detail she forgot to mention. During the post unification period East Germany's population went into melt-down mode. New York Times Columnist Nicholas Kulish put it like this:

Unemployment in the former East Germany remains double what it is in the west, and in some regions the number of women between the ages of 20 and 30 has dropped by more than 30 percent. In all, roughly 1.7 million people have left the former East Germany since the fall of the Berlin Wall, around 12 percent of the population, a continuing process even in the few years before the economic crisis began to bite.

And the population decline is about to get much worse, as a result of a demographic time bomb known by the innocuous-sounding name “the kink,” which followed the end of Communism. The birth rate collapsed in the former East Germany in those early, uncertain years so completely that the drop is comparable only to times of war, according to Reiner Klingholz, director of the Berlin Institute for Population and Development. “For a number of years East Germans just stopped having children,” Dr. Klingholz said.

The newspaper Frankfurter Allgemeine Zeitung reported recently that although 14,000 young people would earn their high school diplomas this year in Saxony, only 7,500 would do so next year. Since 1989, about 2,000 schools have closed across the former East Germany because of a scarcity of children.

Now this situation is quite serious, and needs a long term solution, but it is not as serious as what is currently happening to Latvia, or Bulgaria, or a number of the other former communist states. Unless, of course, the lesson Angela would like to draw our attention to is that East Germany managed to salvage something from what would otherwise be population wreckage by sneaking in under the shelter of another state, with a centralized system of support for pensions and health care. Somehow I doubt it, but perhaps this is what we need to think more about. The EU needs a pan European health and pension system, to distribute the burden equitably. This is the conclusion I reached during my last visit to Riga. It isn't just a Euro related issue, it is to do with having a unified labour market, with people able to move to where the jobs exist, and the pay is better. For years people complained about the absence of labour mobility in the EU. Now we have it, the flaw in the institutional infrastructure is obvious.

Young people are moving from the weak economies on the periphery to the comparatively stronger ones in the core, or out of an ever older EU altogether. This has the simple consequence that the deficit issues in the core are reduced, while those on the periphery only get worse as health and pension systems become ever less affordable. Meanwhile, more and more young people follow the lead of Gerard Depardieu and look for somewhere where there isn't such a high fiscal burden, preferably where the elderly dependency ratio isn't shooting up so fast.

I am sufficiently concerned about this issue, which I think ultimately endangers possibilities of economic recovery all along the periphery, to have created a dedicated facebook page, campaigning for one single issue - that the EU Commission and the IMF give a greater priority to trying to measure these flows, and understand their consequences. I am simply asking that they pressure EU member states to improve their statistics gathering, treat the issue as a priority, and identify an indicator to incorporate in the Macroeconomic Imbalance Procedure (MIP) Scoreboard. Really it doesn't matter whether you are in favour of austerity, or against it, feel more Keynesian than Austrian, or vice verse, all I am asking for is that this problem be taken more seriously, measured and studied.

Bulgaria The Classic Case?

Really there has been a before and after to the financial crisis, at least insofar as awareness of the demographic dimension is concerned. Really, before the onset of the crisis very few people really attached much importance to the question. Since the arrival of the European sovereign debt crisis, and the fiscal cliff debate in the United States, awareness has grown that population ageing probably will slow economic growth, and that previous expectations about levels of pension and health care provision may have been way too optimistic. The latest example of this has been Nobel Laureate Paul's Krugman's comments on how Japan's demographics may be influencing its growth rate. In a tellingly graphic expression he explains that the root of Japan's ailment might be that the country is suffering from a growing "shortage of Japanese".

Once you realise that population shortage may be a problem in Japan, you start wondering where else it might be one. And then, once you begin to look you start seeing the issue springing up like mushrooms all over the place. In Bulgaria for example.

According to the 2011 census, Bulgaria has lost no less than 582,000 people over the last ten years. In a country of 7.3 million inhabitants this is a big deal. Further, it has lost a total of 1.5 million of its population since 1985, a record in depopulation not just for the EU, but also by global standards. The country, which had a population of almost nine million in 1985, now has almost the same number of inhabitants as in 1945 after World war II. And, of course, the decline continues.

As well as shrinking the population is ageing. In 2001 16.8% of the population were over 65. Just 10 years later the equivalent figure had risen to 18.9%. Naturally this means the median population age is rising steadily. It is precisely part of my argument that this surge in median age over 40 has important consequences for saving and borrowing patterns at the aggregate level, patterns which have not yet been adequately measured and identified. Thus the macroeconomic dynamics of a country change. The impact of these changes has not yet been incorporated into the traditional models most analysts use in forecasting.

Naturally the workforce itself is in rapid decline.

The causes of Bulgaria's rapid ageing and shrinking population problem are twofold, low fertility and emigration. This is what makes the country look more like the old DDR and less like Japan. In fact Bulgaria's situation is an extreme case of what is happening in many East European countries, especially Romania and the Baltics. If you want another reference point, Ukraine would be in this group, but even worse, since it is even outside the EU.

Figures on declared emigration show an increase from 19 000 in 2009 to 27 700 in 2010. However, actual outflows are considered to be much greater, based on immigration statistics of th e main destination countries. Spain, the most important destination country in recent years, recorded 10 400 Bulgarians entering in 2010, 7% more than in 2009. Outflows of Bulgarian citizens from Spain also increased in 2010, to 7 600 from almost 5 000 in the previous year (+52%). The number of Bulgarians in Spain increased by 14 500 in 2010, and a further 13 000 in 2011. There are no consistent data for Greece, the second main destination of Bulgarian immigrants in recent years, but it seems that the stock increased less in 2010 than in previous years.

Remittances data gathered by the World Bank give the general picture. Basically there was a large surge following the severe crisis of the late 1990s, and since that time the level of payments has only weakened slightly, on the back of the severity of the crisis in the main destination countries.

Bulgaria is also pretty much what the old DDR would look like if it hadn't fused with Western Germany, namely it much more similar to Hungary than it is to Japan (in the sense I discussed in this post) as it has a significant negative balance on the net international investment position (though not as large as Hungary's), which means as well as being quite poor it is totally unprepared for rapid population ageing (since the text book way to sustain pension and health benefits in a context of increasingly weaker headling GDP growth is normally thought to be to draw down on overseas assets).

Bulgaria also bears comparison with Hungary for the way it has carried out a rapid correction on its external position. This is due largely to remittances and services exports, since the goods balance is still in deficit. But still, the turnround is impressive.

As elsewhere exports have performed very strongly.

But again to no real avail, since domestic demand is deflating so strongly that the economy struggles to find air...... and growth. In this sense it is hard to agree with the IMF Executive Directors when they state in their latest Public Information Notice, following conclusion of the Fund's 2012 Article IV consultation, they "broadly agreed that the currency board arrangement has served Bulgaria well". If allowing a country to drift towards long term melt-down is doing well, I would hate to see what something which they thought was an impediment would do! Some thing is rotten in the state of Denmark, and that something isn't being identified or dealt with.

Naturally part of the problem is that the flow of credit has dried up.

But the other part is surely the one Krugman identified in Japan, the growing shortage of Japanese (sorry, Bulgarians). It is hard to see how you can get serious retail sales growth in a population that is shrinking so rapidly. The end result is that the economy grew steadily into the global crisis, and subsequently has stagnated. This stagnation isn't simply conjunctural anymore, it has become structural, as the decline in domestic demand associated with ongoing deleveraging and population ageing and shrinkage precisely offsets the positive impact of all that export growth.

Not everyone is convinced, of course. The IMF expect the Bulgarian economy to return to a rate of growth of between 3% and 4% after 2014, but looking at the demographics and comparing it with what we are seeing elsewhere that seems pretty unrealistic. What is the expression Christine Lagarde would use? "Wishful thinking" perhaps?

In any event, in the short term the country looks set to significantly underperform any such rosy expectations. FocusEconomics Consensus Forecast panellists expect the economy to expand 1.4% this year. In 2014, the panel expects economic growth to reach the impressive rate of 2.4%.

Growing Political Discontent

Since Bulgaria is a small country, and a poor one to boot, most of the above had been going on virtually unnoticed by the rest of the world. Then last week the Bulgarian government suddenly resigned en bloc. The immediate cause of the crisis which lead to the resignation was the continuing rise in energy costs, a rise which was largely blamed on the Czech provider CEZ. To appease the street protestors the government has now initiated a procedure to revoke the company's licence, a move which has started to raise concerns about institutional protection in the country.

Bulgaria’s State Financial Inspection Agency started a probe into CEZ’s Bulgarian units last year and submitted a report on Feb. 8, saying that CEZ ‘‘evaded requirements of the Law for Public Tenders,” the Energy and Economy Ministry in Sofia said on Feb. 18.
The ministry asked the authority to conduct a similar investigation into the local units of Austria’s EVN AG and Prague-based Energo-Pro, it said.
Bulgaria sold seven power distributors in 2005 to EON SE, CEZ and EVN before joining the European Union. EON sold its Bulgarian companies to Energo-Pro in 2011.

“I regard the statements by Bulgarian officials about CEZ and other foreign companies as very non-standard and see the whole issue as highly politicized because of the approaching parliamentary elections,” Necas said. “I expect Bulgaria, as a member of the European Union, to stick to its international obligations, European law and its own laws on protection of foreign investments.”

Naturally energy prices are not the only issue. The population is tiring of austerity, and living standards that don't rise even as unemployment does.

One symptom of this is that Bulgaria's government sacked Finance Minister Simeon Djankov at the start of last week. Djankov was closely identified with austerity policies, and it isn't hard to read his departure as an attempt to curry favour with voters in elections which are due this summer.

Having said that, the country's government debt at under 14% of GDP is incredibly low, so there is room for flexibility, if it wasn't populist flexibility. The real issue is that simply spending more this year, or next, won't fix the underlying problem, and that problem is unlikely to be addressed until it is recognized as a problem by the institutions responsible for economic policy formulation. As someone once said, de-nile is not only a river in Egypt.

According to wikipedia: "There's a Hole in My Bucket" (or "...in the Bucket") is a children's song, along the same lines as "Found a Peanut". The song is based on a dialogue about a leaky bucket between two characters, called Henry and Liza. The song describes a deadlock situation: Henry has got a leaky bucket, and Liza tells him to repair it. But to fix the leaky bucket, he needs straw. To cut the straw, he needs a knife. To sharpen the knife, he needs to wet the sharpening stone. To wet the stone, he needs water. However, when Henry asks how to get the water, Liza's answer is "in a bucket". It is implied that only one bucket is available — the leaky one, which, if it could carry water, would not need repairing in the first place.

The origin of this song seems to go back, oddly enough, to the German collection of songs known as the Bergliederbüchlein. Ironically Henry's Q&A with Liza fits the quandry facing the countries on Europe's periphery and their lack of constructive dialogue with their core peers about the roots of their problems to a tee.

Friday, February 22, 2013

Spain’s political leaders are in cheerful, almost jubilant, mood at the moment. Economy minister Luis de Guindos, speaking in Davos, declared the tide had turned, and forecast that the Spanish economy would return to growth in the second half of 2013.

As ever, Spain's economy sage is hedging his bets - earth shattering the growth will not be, but grow the economy will, this is his mantra. Put another way, the bottom in Spain's economic collapse has now been passed. From here on in the road may be winding, but it will be up. Perhaps, he suggested, the economy will be stationary in the third quarter, and then we will see growth, albeit ever so slight, in the fourth one. And quite possibly he is right. The core of the issue is not whether the country could see one, or even two, quarters of positive performance, but whether any faltering recovery will be sustained out into the future, through 2014 and beyond. It is here that all the old doubts really emerge.

The brunt of the argument which says the country is now about to see a resurgence rests on the idea that Spain’s government have now enacted sufficient reforms to enable the economy to return to a strong growth path. Optimists claim they will, which the skeptics like myself are not convinced at all.

Certainly Mr de Guindos can point to occasions where he has carried the argument. Back in October last year, when he told an audience at the London School of Economics that Spain didn’t need a bailout they simply laughed. Four months later it is looking increasingly unlikely that the country will seek additional EU aid in the short term. “Spain doesn’t need any sort of bailout,” he told Bloomberg TV recently, and this time no one laughed.

Perhaps the key point here hangs on your interpretation of the word “need”. If paying around 5% on your 10 year bonds is considered to be an acceptable cost for financing your country’s debt – Germany, for example is paying around 1.7% - then there is no need to apply to the EU and trigger ECB bond buying via the Outright Monetary Transactions program. If, on the other hand, you think the country could well benefit from lower funding costs, and the kind of pressure for reform which would be exerted from the outside though a Memorandum of Understanding, then clearly a bailout is needed.

Personally I take the latter view, since personally I think the country still has a long way to go in terms of reforms and since it is clear that introducing more measures that bite would be massively unpopular (and especially in the context of all the recent corruption scandals), the shelter provided by a troika driven program would make implementing them a lot easier.

Pension reform is a case in point. With the country’s elderly dependency ratio rising rapidly, and the number of people paying contributions into the pension fund going down by the month, the whole system is badly out of balance and urgently needs some deep structural reform. According to estimates provided by EU economics commissioner Olli Rehn at the last Euro Group finance ministers meeting, shortfalls in the pension system added more than 1% to the fiscal deficit in 2012. And without major changes in the system this problem will only get worse. Yet Spain’s political leaders are apparently incapable of addressing this problem in public.

Another example is the urgent need to restore additional export competitiveness to the economy. Despite all the claims that the recent labor market reforms need time to work it is already evident that what has been done is far too little far too late. Exports have improved considerably, and the current account balance is moving into surplus. Yet despite this sterling performance the economy still contracted by 0.7% in the last three months of last year, and this during a period when the government was running at least a 7% annual fiscal deficit.

Private domestic demand is weak, and weakening. Retail sales, for example, are on a continuing downward course. As salaries fall while prices continue to rise it would be wishful thinking to imagine this dynamic is going to change, especially as consumption patterns are altered by the population ageing process.

High unemployment (currently just over 26% of the workforce is unemployed) and heavy household indebtedness only add to domestic weaknesses, and it is clear that this will continue to be the case for years to come. No one seriously imagines an unemployment rate under 20% come 2020, and household and corporate deleveraging still have a long way to go.

On the other hand whatever deficit target relaxation the EU Commission gives Spain in 2013, fiscal accounts do eventually have to be brought into balance, so we can expect government spending to remain on a downward trend. The conclusion we are forced to draw is that all we have left are exports, if we want to see Mr. de Guindos’s hopes fulfilled and the economy return to sustainable growth that is.

So to cut through the jargon, and the war of statistics and counter statistics, I want to propose a definition – a country suffering from deteriorating demographics (rapid population ageing) and a private debt overhang is sufficiently internationally competitive when its exports grow quickly enough to fuel headline GDP growth sufficient to generate new employment on a sustainable basis.

This is patently not Spain’s case, and it won’t be in the coming years, so more needs to be done. Much more.
The employment generating caveat is important, since it is only by starting to generate new employment again that the Spanish economy could enter a positive dynamic, bringing to an end the surge in non-performing loans in the banking system, initiating a recovery in the housing market, and giving some sort of stability to consumer demand.

Thus, despite the fact that the country's current account balance is steadily moving into the black, this doesn't necessarily mean that growth is just around the corner. I recently carried out a study of another economy in the process of adjustment, the Hungarian one, where the current account is now regularly positive, but the economy continually falls back into recession. As I point out in that study:

Surely there are lessons from the Hungarian case for the future outlook on the southern periphery of the Euro Area. Improving goods trade balances are steadily pushing current account balances in countries like Portugal, Spain and Greece back into the black. But far from being like Japan and having a large stock of external net savings these countries are more like Hungary with a large negative net external investment position (again hovering near 100% of GDP in all cases) and consequently a large external debt. What this means is that they are totally unprepared to receive the full impact of the kind of population ageing we have seen in Japan, an impact which is surely now under a decade away.

The Hungarian lesson is that exports can do well, very well, and the current account can correct, but the economy can still languish permanently on the verge of recession unable to generate sufficient growth to break out into a sustainable growth dynamic.

Spain, like Hungary, has a very high negative net external investment position - around 90% of GDP - which means the country is extremely ill-prepared for the full impact of an elderly population.

Financial Economy - Real Economy Split

What is beyond doubt is that conditions in the financial economy have improved greatly. The government has opened a market for its debt, the banks have a solid capital base for 2013 and are able to access European wholesale funding markets – even if this is still at a considerable price in terms of interest paid. This is why Mr. de Guindos thinks the need for a bailout is receding.
But of course conditions in the real economy continue to deteriorate. Most estimates for 2013 are for a larger contraction than that estimated by the government (something which has become habitual), and many observers continue to expect the negative growth trend to continue in 2014. Unemployment was already over 26% as 2012 drew to a close, which makes 27.5% next December a virtual certainty and a number over 28% entering 2014 horrifyingly possible.

So despite all the positive “talking up” that Spain’s economy is receiving from well-wishers at the international level, the disconnect between the financial economy and the real one has now become markedly pronounced, and the clearest evidence for this is that what are now, at least for the time being, well capitalized banks are still unable to provide systematic credit to the deteriorating private sector.

And if the private sector doesn’t improve, then the banking system will surely need more capital further along down the line. Even the relaxation of deficit targets comes at a price – next year (2014) government debt will almost certainly slip through that psychological 100% of GDP level, and still be heading upwards. Meaning that at some point a sovereign debt restructuring in Spain certainly can’t be ruled out.

Perhaps the worst of all assumptions that policymakers seem to be making is the one that “economies always recover”, an assumption which seems to be based on some sort of quasi-religious version of the “hidden hand” theory. Indeed, all that is necessary to makes this a less than universal generalization is one counter example, and unfortunately the real world is populated by several of them. Argentina in the 20th century would be one, the country started out among the richest globally, and look how it ended the century. Twentieth century Japan would be another, and once you start to look you can surely find more (try Ukraine, or Hungary). So recovery isn’t automatic, and something has to happen for recovery to occur. That something isn’t present in Spain at the moment, and indeed the danger is that as conditions deteriorate the contraction becomes self-perpetuating.

One of the less well commented features of Spain’s boom during the early years of this century is the way the arrival of economic migrants fueled a significant part of GDP growth. The country’s population grew by more than 6 million (from 40 to 46 million) in the first eight years of the century, raising employment levels in both the formal and the informal economies.

Migrants are still arriving, but the balance has now turned negative. According to data from the National Statistics Office, as of last September the net outflow was around 20,000 a month and accelerating. That is to say a quarter of a million a year, or a million every four years. And the final numbers will almost certainly be much larger.

So a country which already doesn’t have enough people working to pay for its pension system, now faces having less and less as time goes by, while the number of pensioners looking to claim will only grow and grow. In part that is the end result of sitting back and watching a 1.3 child per woman fertility rate for over 30 years.

But to this grave underlying problem is now being added a new and potentially more deadly one. Those leaving are not only migrants who came earlier. Increasingly young educated Spanish people are upping and leaving, and unlike in earlier periods many who go now will never return. Not only is there a massive human capital loss involved here, trend GDP growth is evidently being reduced as the workforce steadily shrinks, while all those unsellable surplus-to-requirement houses become even less sellable. And so we may go on in what has all the hallmarks of a non too virtuous circle. So next time Luis de Guindos proudly proclaims that economic conditions are improving, he might care to consider stopping for a moment to reflect on the possibility, nay the almost certain reality, that Spain’s economic contraction now feeds on itself.

The country is no longer waiting, as the New York Times' Landon Thomas so aptly put it, for Mr Rajoy. Indeed, Mr Rajoy himself has now turned his famous indecision into a virtue. "Sometimes the best decision is not to take any decision, and that itself is a decision," he told enthusiastic supporters in his Partido Popular parliamentary group last week. Or as one PP supporter put it to me last week, it now looks like Mariano Rajoy took a very intelligent decision last autumn, saying he would ask for a bond buying programme if the country needed it and doing nothing. Only time will tell if this was such a good decision as it seems. In the meantime far from waiting for Mr Rajoy, many young Spaniards are now only waiting to see who will be the last to leave so they can ask them to turn the lights out.

Monday, February 11, 2013

According to Wikipedia, in complex analysis an essential singularity of a function is a "severe" singularity near which the function exhibits extreme behavior. The category essential singularity is a "left-over" or default group of singularities that are especially unmanageable: by definition they fit into neither of the other two categories of singularity that may be dealt with in some manner – removable singularities and poles.

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No need to panic, a lot of analysts tell us, since far from being on the verge of some earth shattering event Japan has invented the economic equivalent of a mechanical perpetual motion machine. Or as Nobel economist Paul Krugman put it recently, “while there is much shaking of heads about Japanese debt, the ill-effects if any of that debt are by no means obvious”. Maybe there is just one word missing here - yet.

This, however, will not be the viewpoint taken here. The rise and rise of Japanese debt is far from benign, and the dynamic, we are convinced, will at some point become unsustainable. Unfortunately by the time we reach that point it will be too late. Indeed, given that we agree with Krugman that the underlying cause of Japan’s malaise is demographic, after several decades of ultra-low fertility in all probability it already is too late. The root of the problem is, as he says - wait for it - that there is "a shortage of Japanese".

Far from being like that woeful economist so tellingly characterised by Keynes, the one who through many travails and pages and pages of equations is only able to tell us that when the storm is long past the ocean is flat again, we feel we have more in common with the character so ably played by Mike Shannon in the Jeff Nichols’ film “Take Shelter” - "there’s a storm comin, one like none of you have ever seen before…."

If You Print Your Own Money, And You Run An External Surplus, How Can There Be a Problem?

Japan’s problem is benign, so the argument goes, since the country has an external surplus, and can print its own money. As a result there is a savings surplus, and no problem selling government debt, even at ridiculously low interest rates. And since the interest paid remains ridiculously low, then there is no problem servicing the debt, and if there ever was, why then the Bank of Japan could just buy even more of its own government bonds, effectively driving the interest rate even lower. In theory there is no good reason why it couldn't even follow the lead being currently set in Germany, and push the rate into negative territory. Heck, the government would then be even earning income on its debt. It would be a good investment.

But somehow or other this view fails to convince. In particular it fails to get to grips with why Japan has gotten into this situation. It also doesn't offer any kind of road-map for how the country could ever get back to the sort of monetary regime that was once widely considered to be "normal". Or perhaps, in the world we now live in, as the US novelist Thomas Wolf once put it "you can look homeward angel" but in fact "you can never go home again". Which is just a very poetic way of saying that time has an arrow, and that some processes are irrevocable and irreversible.

So, if this is what you were hoping for, then bad luck, since there is simply going to be no such thing as a return to normality for Japan. That being said, what we have to avoid at all costs is Japan becoming the "new normal", the text book case of a society where the fundamental mismatch between declining demography and appeasing an ever older electorate with populist politics leads to complete dysfuncionality, a dysfunctionality which is then reiterated in one country after another. From this point of view it is fascinating to note just how fast Japan is getting towards "the end of the road". Some investors have even been getting ahead of themselves and frantically shorting Japanese debt in the anticipation of future and continuing credit downgrades, without asking themselves the really awkward question - what happens to the country if it is eventually forced to default on its debt.

If on the other hand we are able to see that something is going on in Japan which is neither normal, nor desirable, nor sustainable, then we just might like to ask ourselves what then gets to happen next? Certainly there is nothing in conventional economic theory which can help us anticipate the answer, since this kind of end of the road point has not been foreseen, anywhere.

It’s equally fascinating that so few people are really talking about this development at the moment. The assumption that things can more or less go on and on is widespread both in and outside Japan. Despite the frequent references to "Japan's lost decade", the country has now lost not one, but two - what was it Oscar Wilde said, losing one child could be an accident, but losing two surely has to constitute negligence - and as things are shaping up we seem to be all set to have a third one in front of us, markets and weather permitting, always assuming the Japanese government remains able to finance its debt.

Yet at the moment there seems to be no danger of that. Japan has become flavour of the month among investors, following the continuing verbal interventions from prime minister Shinzo Abe. Against all odds, people are buying the story that an inflation target of 2% is attainable, and that the country can permanently devalue its currency by a sufficient amount to produce an ever larger trade surplus, despite the war of words that has already broken out about "currency wars". Or perhaps it has become convenient to believe the impossible will be possible, simply to make money on short term trading positions. Given the quantity of long run uncertainty, this seems to be the main obsession of markets right now, following the dictum of the 1960s philosophy made famous by Jack Trevor in the film "Live Now, Pay Later."

A Country Growing Short Of People?

But let’s keep the debt issue for later and start with the demography – here Japan is certainly a real global leader, in this case for its advanced population ageing. Japan is not only an ageing society: It’s THE ageing society. Following decades of an ultra low birth rate and negligible immigration, it faces a steady decline in its working-age population and a rising dependency ratio for decades to come. There is no changing this now. Even some "miracle" reversal of the fertility problem would take decades to work through, so whatever happens next, things will get worse before they get better.

Japan's population - in median age terms - is the oldest on the planet. Median age is around 45, and it will continue to rise. There is no real prospect of it coming back down again, since the process it is experiencing appears to be totally irreversible. Forecasts see the median age in Japan rising to more than 50 within the next two decades, and really here we are breaking totally unknown territory – no society in the whole of human history has ever been this old.

Given this prospect, it is natural to expect that the country should save heavily to make provision for the future--and it does. But a country with an ageing and declining workforce gets an additional problem, one of structural demand deficiency due to the changing balance between saving and borrowing. Investment opportunities in Japan are limited, so that businesses will not invest all those savings inside the country itself. The only surprising thing is that people are still surprised by this.

This demand deficiency results in a process we have come to call export dependency (leveraging the global rather than the local economy in the search for customers). Japan has now well passed the threshold at which the economy, as a modern market economy, can rely on domestic demand and domestically oriented investment to grow. The trouble is, that given its export sector cannot grow fast enough to keep pace with the contraction in private internal demand, the country has become increasingly dependent on large fiscal deficits to keep the ship right side up.

However contrary to the expectations of the classic life cycle model, the conclusion we have come to is that rapidly ageing societies will not, in the main, be characterised by aggregate dissaving but rather by the fight against it. In the context of international capital flows this means that rapidly ageing economies will be characterized by an external surplus and not, as theory would predict an external deficit. According to the said life cycle theory, savings by consumers should not affect total aggregate savings in the long run because savings today, by definition and through the idea of consumption smoothing, turns into consumption tomorrow. Yet this might be the wrong way to read the life cycle hypothesis: ageing may be associated with the propensity to run an external surplus and this may lead a country to a state of export dependency.

The conclusion we draw from the above is a simple one – if Japan is going to see a decline in working population over the next several decades (and possibly much longer, since so long as fertility remains below replacement rate each generation will be smaller than the previous one) and if this lies at the heart of the deficient domestic demand deflation problem, then it means the issue is a deep structural one which won't be resolved by any kind of "kick start", however large. The only consequence of having permanent fiscal injections will be not to give stimulus, but rather an accumulation of debt that will be increasingly harder for those smaller and poorer workforces to pay down in the future – especially if the process is associated with ongoing deflation.

To use an analogy - it isn't simply a question of a planet which has slipped off or strayed from its orbit (or “good equilibrium”), and just needs a nudge to get it back on, what we have is a planet which has veered off onto a whole new trajectory, one which leads to who knows where. This situation was never contemplated by the founders of neoclassical theory, and yet, having started in Japan, the phenomenon is now extending itself steadily across all developed economies in one measure or another.

As long as Japan is the only guy in town facing this kind of problem, there is a simple solution - invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations.

Up to the arrival of the global financial crisis Japan played this game well because it was the only one playing it. The problem is that now every single OECD economy, one after another, will steadily be looking to do the same. So in similar fashion, those who urge a solution to Europe's imbalances via an increase in German fiscal deficits to stimulate consumption miss the point: arguably what people in these societies need to do is save more, not less, and certainly when it comes to the public sector.

External demand and foreign asset income become crucial elements of growth for ageing societies, and if we end up with every developed country trying to export its way out of the mess it is surely not going to work! The first signs of this can already be seen in the Euro Area, where the sterling attempts of the countries on the periphery to escape from their trap through the ramping up of exports is simply leading to economic stagnation, since the core countries (largely net savers) are unable to take up the demand slack.

What makes the country different is that in Japan the cracks are starting to become visible. The positive external balance which is essentially the only source of growth for the economy is quickly evaporating. The trade balance is now well negative in large part because of the continuing need for energy imports (mainly LNG and oil) and this has started to drag the current account down. Even worse the income balance is also now falling lead the country to recently post its lowest current account surplus since 1985.

Seen in the light of the above, these recent trends in Japan’s external balance are deeply worrying.

To become even more worried, let’s get back to the debt.

A Balloon Which Just Grows And Grows

Amazingly, Japan is the only developed economy still expanding its annual budget deficit even though the economy is saddled with, by far, the biggest debt burden – gross government debt is now around 235% of GDP. Now many make light of Japan's economic growth problem since with the 15 to 65 population falling, output per worker is not performing badly. As Paul Krugman so cogently puts it, "you can argue that demographically adjusted, the whole tale of Japanese stagnation is a myth." You could, that is, if it weren't for the growing debt. Simply thinking about GDP per member of the active population is very misleading, since what you need to thing about is the elderly dependency ratio, how many people, that is, each member of that steadily shrinking workforce has to support. This is where the real action is.

Evidently a large chunk of this growing debt problem is demographically related. In fact, since the early 2000s, Japan’s non-social security spending has been reasonably well contained and, at about 16% of GDP in 2010, it was the lowest among G-20 advanced economies. Meanwhile, social security costs have risen steadily due to the steady attrition from population aging. Social security spending rose by 60% between 1990 and 2010, accounting for about half of consolidated government expenditures in 2010. Moreover, a sustained increase in the old-age dependency ratio has implied larger social security payments supported by a shrinking pool of workers, and again this has rapidly deteriorated the social security balance.

As long as the interest rate is close to zero, even sky-high debt seems to be fine. But, as the IMF puts it: "Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable. Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift.”

And the IMF draws a scenario, in which a wrong combination of circumstances at an inopportune moment in time could easily send Japan spiralling to where Italy and Portugal are now: “Market concerns about fiscal sustainability could result in a sudden spike in the risk premium on JGBs, without a contemporaneous increase in private demand. Once confidence in sustainability erodes, authorities could face an adverse feedback loop between rising yields, falling market confidence, a more vulnerable financial system, diminishing fiscal policy space and a contracting real economy".

We’re just now seeing the beginning of this scenario. The average rate of maturity on JGBs is being pushed down due to investors buying the short end in combination with the purchasing program from the BOJ. Where have we seen this before ... oh yes, the eurozone periphery. You try to see what yield Japan would need to pay for for a MARKET based 10y or 30y issuance of a decent size. Our best guess is way, way above its nominal growth and herein of course lies the problem. Japan ran a 10% deficit last year and there are no signs of consolidation in 2013. Meanwhile the current account surplus is starting to play the vanishing man act.

Japan will run out of sufficient savings to buy the whole issue of JGBs by 2016, but the possibilities are the market will respond sooner. If the Japanese government continues to issue debt, the Japanese economy is going to run out of savings to buy the new debt. The share of government debt to total currency and deposits will soon reach close to 100%. At this point of the endgame, there is no way out for Japan: either the central bank or foreigners must take up the bid, or Japan must begin to sell off foreign assets. Markets will price in the endgame before it happens.... then it will be game over!

What does game over mean?

How does a country accept its fate of having no other chance of growing other than simply growing old?

How does a country accept its fate of seeing its private savings evaporate? How can a country get along with the discovery that what was seen as a secure source of private wealth and old-age provision, national government bonds, just dematerializes?

Of course, each country is different, especially if it goes through a heavy crisis. And, at least, over the years the Japanese built up a strong net external investment position which leaves the current account strongly positive despite the negative goods trade balance due to the high income flow from investments abroad. This is very different from Italy and Portugal, countries which have long run both trade and current account deficits and have very poor net external investment positions. But these external assets and the internal savings are distributed differently, and in case of heavy losses on the domestic side – will the Japanese Gerard Depardieus and those leading global companies with large foreign assets still be happy to pay the surcharge needed for elderly care of all those elderly people that lost their savings because they trusted the government?

Or Japanese young people, will they still be prepared to stay and work in a country which may well have some of the highest income tax rates on the planet?

No matter how Japan will act in its battle to survive the endgame, it is going to provide us with a fascinating experiment to follow because whether it succeeds or not will tell us a lot about our own future, and of how the rest of the OECD will cope with the rapidly ageing societies they have in their own back yards.

Italian Economy Watch

Japan Economy Watch

Hungary Economy Watch

Latvia Economy Watch

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About

Edward 'the bonobo' is a Catalan economist of British extraction based in Barcelona. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".
He is currently working on a book with the provisional working title "Population, the Ultimate Non-renewable Resource".
Apart from his participation in A Fistful of Euros, Edward also writes regularly for the demography blog Demography Matters. He also contributes to the Indian Economy blog . His personal weblog is Bonobo Land . Edward's website can be found at EdwardHugh.net.